The global mortgage industry has evolved over the last 50 years at great pace. This has been particularly the case with the advent of the process of “securitisation”, whereby bundles of mortgages are packaged together and sold on to third-parties, thereby liberating the balance sheets of banks to engage in a new round of cost-effective lending. This has in turn led to the development of liquid secondary markets in mortgage-backed securities that are actively traded by investors all around the world.
Innovation in the primary mortgage market has, however, been relatively stilted. Since the turn of the 20th century, global housing finance has been dominated by either fixed-rate or variable-rate mortgage instruments. While there has been some innovation on the periphery of these products (e.g., interest-only contracts, home-equity loans, etc), this has not resulted in fundamental changes to the way in which consumers finance their home ownership choices.
Perhaps the one exception here is the “reverse mortgage”, in which the mortgage's interest rate compounds or “rolls-up” over time, thereby enabling the consumer to defer the cost of the finance until the time that they either die or sell their property. Under a reverse mortgage, there are not, therefore, any ongoing interest and principal payments to which the consumer is subject. Reverse mortgages are, furthermore, limited in their application to a specific class of consumers: namely, the elderly. Indeed, the providers of these products quite explicitly prevent consumers under the age of, typically, 65 from qualifying for such loans. In addition, reverse mortgages are not used to purchase new properties: on the contrary, they are restricted for use as “equity-release” mechanisms for those asset-rich yet cash-poor owner-occupiers who are currently living in their own residence. Reverse mortgages are not, as a consequence, relevant to the traditional housing finance industry. As a final point, reverse mortgages are—in their own way—simple interest-bearing securities that appeal to fixed income investors only. Reverse mortgages do not in any manner whatsoever provider the lender (or, in the event of securitisation, a third-party investor) with any exposure to the risks and returns associated with changes in the value of the underlying properties over which the mortgages are held (i.e., the residential real estate asset-class).
In 2003, a landmark government report in Australia (see C. Joye, A. Caplin, E. Glaeser, P. Butt, M. Kucynski (2003) New Approaches to Reducing the Costs of Homeownership; A Report for the Prime Minister's Homeownership Taskforce, Menzies Research Centre) unlocked the door to a new universe of housing finance possibilities, with particular emphasis placed on allowing consumers to draw on the “equity” side of the home ownership balance sheet while at the same time supplying institutional investors with efficient access to the residential real estate asset-class for the very first time. This was in effect a vastly more advanced suite of proposals to the many (mostly distant) arrangements that have been suggested in both the professional and academic worlds.
There has for some time existed various cottage-industry style shared-equity programs (almost exclusively in the academic and public sectors in Australia, the UK, the US, and New Zealand) targeting faculty and low-income households, in addition to isolated incidences of so-called “shared-appreciation” mortgages in the private sector in the UK and US. There has not, however, ever been a successful example of an enduring market-based programme in which significant numbers of consumers have shared the long-term economic exposures to their owner-occupied homes with similarly large numbers of external investors. The 2003 Australian Prime Minister's Home Ownership Task Force Report (hereafter “the Report”) outlines merely the conceptual architecture through which such a market could be developed.
In particular, that Report argues that while for centuries businesses in need of funds have been able to avail themselves of both debt and equity, households that aspire to expand have been restricted to the use of mortgage finance. And so, despite the ever-growing sophistication of corporate capital markets, consumers around the world have been forced to use only the crudest of financial instruments. The Report contends that the implications of this deficiency vary from the merely inconvenient to the extremely tragic. Suffice to say that many of the grave economic complications that are manifest throughout the course of an occupier's life-cycle can be attributed to the “all-or-nothing constraint” on home ownership (i.e., the fact that households must retain 100% of the equity in their homes, and are prevented from sharing their investment in the residential real estate asset with third-parties).
The Report describes how this all-or-nothing constraint on home ownership (also referred to as the “indivisibility” of the housing asset) plagues consumers right throughout the life-cycle. For example, young families scramble to scrape together funds for a down payment so that they can graduate from the difficulties of rental accommodation to the suggested nirvana of owner-occupation. This period of intense saving often induces a considerable consumption squeeze and severely constrains lifestyle choices. In fact, the bulk of young households in some countries are obliged to commit around 70% of all their wealth to one highly illiquid and very volatile asset—residential real estate. Then there are the costs associated with servicing the mortgage and maintaining the home. The weight of such commitments frequently forces families to endure Spartan-like conditions in the early to middle years—the so-called “house poor”. In later life, most manage to pay off all their debts and live in the home clear and free. Unfortunately, by this time retirement beckons and the majority of dwellers have precious little income (other than an old age pension). They are now “asset rich, but cash poor”. Indeed, a significant proportion of the elderly populate the lowest two income quintiles.
In an attempt to rectify the asymmetry between corporate and household capital markets, the Report proposes that contemporary arrangements could be augmented by a more flexible system that would furnish families with the option of using both “debt” and synthetic “equity” finance when purchasing their properties. Under the Report's proposal, housing would be financed by using a traditional mortgage in combination with synthetic equity capital, contributed by the same or a separate lender via a “state- or collateral-dependent” debt contract, whereby the normal interest rate is replaced by an entitlement or claim to the future positive and/or negative price movements associated with changes in the value of the underlying property over which the debt instrument is held (hence the “state-dependence”). The Report claims that these “equity finance” arrangements could give rise to, amongst other things: a 30% plus reduction in the upfront costs of home ownership; an increase in the consumer's disposable income once they move into their home (as a result of the diminished debt servicing obligations); a reduction in their risk of default given the smaller size of their traditional mortgage; and a material increase in the household's liquid wealth at retirement since they no longer have to dedicate most of their savings to the otherwise illiquid and inaccessible dwelling asset. And so, whereas this household might once have been priced out of the market, the Report maintains that the use of equity finance has made home ownership a much more realistic ambition.
The Report also claims that the use of equity finance would constitute a safer equity-release mechanism for the asset-rich yet cash-poor elderly (who represent an increasingly large proportion of the population) in comparison to reverse mortgages. The Report posits that it is an unfortunate fact that the illiquidity of housing equity obliges many aged individuals to select between two starkly different paths. They either: (1) continue to teeter on the precipice of poverty, while retaining the right to occupy the home that they have cherished for so long; or (2), alleviate these monetary woes by selling their current abode, moving to a smaller one, and possibly jeopardising relationships that have been defined by the area in which they live. The advantage implied by the latter option is of course an improvement in the homeowner's otherwise dim consumption prospects.
The Report notes that the equity-release opportunity has not gone unnoticed by members of the financial community. In fact, there have been several attempts to provide home owners with a vehicle through which they can liberate wealth held in the form of housing. These include products such as reverse mortgages, shared-appreciation mortgages, and home-equity loans. Notwithstanding the recent growth in reverse mortgages, the success of these offerings has been a slow-paced affair, to say the least. The majority of older dwellers spent their middle years constrained by the creditor's leash, and they are understandably reluctant to burden themselves with any additional debt (at least in its conventional incarnation). At the same time, many choose not to trade down to a smaller home, since this usually requires them to move to an entirely different geography, which then raises the spectre of sacrificing social ties that are predicated on the locational proximity of the two parties. These strong psychological bonds to the current property can create a substantial roadblock to higher levels of consumption—so much so that most financial planners tend to ignore the owner-occupied home when assessing the resources available for use in later life.
In light of the above, the Report argues that there is little doubt that by eliminating the “indivisibility” of the dwelling asset (i.e., by way of sharing the equity entitlements with third-parties) one could open up a new realm of possibilities for elderly occupiers. In contrast to many of the alternatives, the Report submits that collateral-dependent equity finance offers elderly owners three particularly attractive attributes: (1) it prevents them from having to move from their current homes and incur all of the associated emotional stress; (2) they do not have to assume traditional debt; and, most importantly, (3) in comparison to a reverse mortgage, equity finance instruments leave consumers, in the worst possible contingencies, with a significant share of the equity in their home. Reverse mortgages, on the other hand, would expose these same borrowers to the risk that the ever-growing loan amount will eventually balloon out to consume 100% of the value of their homes, thereby subjecting them to the spectre of little, or even negative, equity.
Another important advantage afforded by equity finance is the valuable insurance service the lender supplies by sharing a proportion of the downside risk (i.e. the risk of property price declines). The simple fact is that most homeowners own one house, situated on one street, pointing one direction, with all its manifest peculiarities. Indeed, economists estimate that the “idiosyncratic” risk attributable to a single-family home is more than two to three times that which one would impute to a well-diversified portfolio of property (and of course, the use of large amounts of leverage only serves to magnify these hazards).
The Report's equity finance instrument was designed such that when the housing market declines, the cost of capital is low, while when it booms, it is comparatively high (which is obviously ideal from the consumer's perspective). That is to say, if there is no price appreciation, households are not obliged to make any economic transfers to the lending institution or individual (or synthetic equity provider) over and above the original loan amount—certainly a superior outcome to paying interest on a massive mortgage. In the event that there is price depreciation (as was the case in the early 1990s), households benefit from being able to redistribute some of these risks to the investor. All other forms of debt finance (including reverse mortgages), by way of contrast, offer no such flexibility, and as such are clearly distinguished from equity finance mortgages.
While the case for investors is complex, it would appear to be just as attractive. Residential real estate is, after all, the largest asset class on earth, valued at $70 trillion in developed countries alone. Since 1960, it has outperformed stocks, bonds and real estate investment trusts on a risk-adjusted basis. It is also a highly “uncorrelated” investment category, which could provide prospective participants with significant diversification gains. The experience of the stock market crashes of 1987 and 2001 are a classic case in point: while global equities suffered significant losses, owner-occupied housing in Australia, Europe and North America delivered tremendous price appreciation. And so, if institutions could spread their eggs among a greater number of baskets, they would be able to appreciably increase (decrease) portfolio returns (risk) while holding risk (returns) constant. Of course, it is currently impossible to access real estate's risk-return profile in a well-diversified fashion or to trade home equity on a liquid market.
While the Report provides an impressive articulation of the equity finance opportunity and outlines the skeletal features of how these arrangements might practically develop, it does not specify the precise contractual solutions to more fundamental issues associated with the economic pricing of the equity finance contract, including for example, prepayment by consumers who want to stay in their homes, the refinancing of the traditional interest-bearing mortgage with which it is to be bundled, and owner initiated renovations to the property that serves as the contract's underlying collateral. Consequently, on the consumer side of the equity finance ledger (i.e., setting aside the capital markets challenges for the time being), the Report did not provide comprehensive proposals as to how one could confidently solve crucial problems associated with “adverse selection” (e.g., borrowers who prepay their equity finance instruments to the detriment of the lender) and “moral hazard” (e.g., borrowers who do not seek to maximise the value of their properties, or engage in behaviour that detracts from its future sale proceeds). The Report is also silent on the critical technological systems that would enable the lenders of both the traditional interest-bearing mortgage and the equity finance instrument to avoid conflicts of interest and thereby interact advantageously.
On the capital markets front, the Report once again sketches out the broad nature of the equity finance opportunity, while shedding no light on the methods, systems, and technologies that the distributors, lenders, underwriters and/or funders of these equity finance contracts must use in order to identify, screen, select, securitise, and service such assets, and manage the overall portfolios into which they are placed on an ongoing basis through time, in order to enable a successful and self-perpetuating interaction between the consumer and investor sides of the equity finance market.
The many otherwise intractable commercial problems highlighted above have motivated the present developments.
There have been a number of private and public sector programmes that have tried to implement arrangements somewhat similar to the equity finance initiative of the abovementioned Report.
In 1987, the US Congress created the Home Equity Conversion Mortgage (“HECM”) Insurance Demonstration Program under the National Housing Act to: (1) facilitate the conversion of home equity into liquid assets to meet the needs of elderly home owners; (2) encourage and increase participation of the mortgage markets in this process; and (3), determine the extent of demand for home equity conversion and the types of mortgages that would best serve the needs of aged individuals. Under the HECM Program, elderly home owners could assume a reverse mortgage secured by the equity in their residence. As the borrower receives payments, the amount of debt tied to the mortgage rises over time. This debt is non-recourse, with the implication that only the value of the dwelling may serve as collateral, and other personal assets cannot be seized if this value is not sufficient to pay off the loan.
Originally authorised by Congress to insure 2,500 reverse mortgages through to September 1991, the Department of Housing and Urban Development (“HUD”) designed the demonstration program in consultation with other federal agencies and implemented it with a Final Rule in July 1989. The next year, Congress extended the demonstration through to 1995 and expanded HUD's authority to insure 25,000 mortgages. It subsequently amended the program again to authorise HUD to insure up to 50,000 mortgages through to Sep. 30, 2000. And in October 1998, Congress increased the number of allowable outstanding loans to 150,000.
Yet for reasons outlined previously, such interest-bearing reverse mortgages—which afford the lender no access to the risks and returns associated with the underlying property—are very different to equity finance instruments.
In the US also, state and time-dependent shared “appreciation” mortgages (“SAMs”) were developed in response to the inflationary pressures experienced during the 1970s, and are the nearest that the prior art approaches the “upside” and “downside” collateral-dependent equity finance mortgage techniques disclosed herein. When the general price level rises, there is a front-end loading of interest payments in standard mortgage instruments. That is, inflation causes nominal rates of interest to rise while simultaneously driving down the real value of outstanding debt. A SAM reduces the extent of this front-end loading by enabling users to pay lower rates of time-dependent interest today in exchange for investors receiving a collateral-dependent share of the inflation-induced increase in the value of housing in the future.
The SAMs offered in the US were relatively short term (generally 10 years in duration), and combined sizeable cuts in interest payments with a substantial sharing of appreciation. One product in particular presented households with a 6% per annum interest rate concession in return for a contingent claim on 40% of the appraised price growth. Very few such instruments were in fact issued, in part because of their nebulous tax treatment. The primary mandate of the IRS of the USA is to collect tax and prevent tax avoidance. Regrettably, this seems to have coloured its attitude when called to rule upon the prickly subject of whether a SAM entitles householders to mortgage interest deductions. In the end, in 1983 the IRS decided (somewhat reluctantly, if one reads between the lines) that both the fixed and contingent interest payments on a specific SAM product were indeed tax deductible). The ruling was deliberately narrow, and as a further sign of inertia, the IRS has twice since announced that it would not issue any additional determinations on the subject, most recently in 1996.
The consequences of the IRS's attitude towards the classic SAM continue to ripple throughout the US housing market to this day. There was of late, for instance, a well-funded and researched attempt to launch just such an instrument, with the National Commerce Bank Services (“NCBS”) of Memphis offering to acquire contracts from local issuers in the Southeastern states, and Bear Stearns undertaking to sell the securitised bonds. Yet the product was withdrawn almost immediately, in a large part because of ongoing questions about the stance of the IRS. To illustrate the manifest ambiguity, consider the advice NCBS offered to potential clients.
“The application of the federal income tax rules to a SAM is both uncertain and complicated, and the rules will affect each borrower differently. Accordingly, you must talk to your tax advisor about the consequences of borrowing under a SAM.”
The Reverse Mortgage Advisor Volume 3.2 (Spring 2000) edition contained the following statement about another shared-appreciation type product, developed by Financial Freedom, with the standard time-dependent interest element, “The new product, called the home appreciation loan (“HAL”), is still under development and may be unveiled in the third quarter of this year. The HAL would have many characteristics of a reverse mortgage. For example, a borrower could take the loan proceeds as a lump sum, and the loan wouldn't have to be repaid until the borrower dies or sells the home. The repayment obligation would be the loan amount borrowed, plus accrued interest and a predetermined percentage share of the home appreciation during the loan period, which would be negotiated upfront between Financial Freedom and each borrower. The greater the percentage, the larger the loan size. For example, if a borrower's home was valued at $150,000 when the HAL was made, and the home was sold five years later for $180,000, the borrower would have to pay Financial Freedom a percentage of the $30,000 gain from the sale of the home.” As of the priority date of the present application, there has been no commercialization of the proposed product by Financial Freedom, or its parent, Lehman Brothers.
More recently, bankers, employers, local governments, and not-for-profit organisations have launched shared appreciation products in many of America's most expensive housing markets, from Howard County, Maryland to San Diego, Calif. These contracts generally have one common element: instead of a SAM replacing the conventional first mortgage, as in the experiments of the 1980s, the scheme supplements it, usually in the form of a second mortgage or, in one case, a co-ownership agreement (with respect to the latter, see also U.S. Pat. No. 5,983,206 for example of a mortgage combined with a joint venture equity partner). Typically, an equity source provides 20 to 25% of the purchase price (in one programme this percentage has risen to 50%) in exchange for a similar share of the appreciation at point of sale. The remainder of the acquisition costs are financed by a small down payment and a conventional first mortgage of 70 to 75% of the home value.
These initiatives have usually been implemented as either public-purpose programmes to help low-to-moderate income families or as employer-sponsored schemes to assist employees acquire a home (the latter of which is most prevalent among universities in comparatively expensive markets such as Harvard, MIT, Stanford and the University of Colorado). As such, it is not surprising that most have operated on a small scale, producing at best only a few thousand financing arrangements nationwide. They do not appear to be shaped in a way that can attract significant private capital for two basic reasons: (1) the current design does not give rise to returns that would be high enough to appeal to outside investors—equity partners do not normally receive any premium for giving up the decision-making rights, nor do they receive any rental yield that would usually arise in the context of a direct equity investment in residential real estate; and (2), the existing programmes do not share a common contractual structure, with different parameters on everything from duration, to repayment formulas, to the legal structure. As a consequence, these efforts have not spurred the emergence of a tradable financial instrument commodity in housing equity, which would provide the homogeneity that the secondary markets so desperately seek.
In 1996, Northbay Family Homes, a not-for-profit organisation in the San Francisco Bay Area, developed a product known as the Community-Assisted Shared Appreciation (“CASA”) contract. Unlike its peers, CASA has attracted considerable investment from banks, development firms, and other private entities that supplement the government funding. The investors obtain an equity stake in the house in the form of a second mortgage, which is then backed up by the local authorities with a third mortgage. The second and third mortgages each equal 10% of the sales price, for a total equity investment of 20%. Both the investor and the government agency get their funds back when the home owner sells the property. If the occupiers have not sold after 14 years, they are required to refinance and buy out the investors if they can afford to do so. Significantly, when the house is disposed of, the family receives 40% of the appreciation, while the equity partners collect 60% (most of which goes to the private institutions). Due to the high prices in the San Francisco area, this initiative has proved to be extremely popular with residents.
Indeed, all of these CASA programmes have experienced demand that has been much greater than the available supply. In Howard County, for instance, a recent financing round for nine buyers attracted 347 applicants. Part of the reason demand has exceeded supply is that most schemes have offered financing on exceptionally favourable terms as a result of the flexibility afforded by public finding. But the fact that even the CASA program has galvanised strong demand shows that there exists the potential for a much larger consumer market than is presently the case.
In all of the above cases, the state-dependent nature of the shared-appreciation mortgage instrument is confined exclusively to one area: events in which the value of the house increases. As a consequence, the cost of capital borne by the consumer is not in any way affected by events in which the value of the property declines. Lenders under these arrangements apparently have not conceived of a situation in which they would be willing to share any of the “risks” associated with home ownership. Put differently, they have not thought of offering households an “upside” and “downside” collateral-dependent mortgage (or, simply, an “equity finance mortgage”) arrangement where a proportion of the principal amount would actually be forgiven in the event that the price of the property falls, in addition to foregoing or not foregoing all other forms of time-dependent interest. In many respects, this downside risk sharing component of the mortgage contract disclosed herein resembles an insurance service, insofar as it seeks to limit the occupier's exposure to contingencies in which they would suffer a wealth loss. While many people would have one believe that residential real estate is an incredibly safe investment, at the individual home owner level nothing could be further from the truth. The simple fact is that a very large number of households realise both nominal and real losses when they come to sell their homes. And yet in the current housing finance market, there is nothing that they can do about it—that is to say, they are forced to assume 100% of all the economic risks inherent in owning a home.